Sometimes, I try to put on fancy trades. Some work well. Some not so well, even if the overall balance is in my favor (at least so far... :-) ).
Then the other day I remembered that some guy once said that "the best trades are always the simplest ones". So I thought "what about the old delta hedging trick for a change?". It's simple. It's been explained numerous times in the academic literature, with Hull and Natenberg at the top of the list. Every derivatives market apprentice went through it again and again before each interview...
So I told myself: just buy cheap options or sell expensive ones, then continuously hedge the resulting delta at no transaction costs based on the future realized volatility. Like in the books... Continuously... At no transaction costs... Based on the future realized volatility... Hein!
Guess you got me here: not that simple in practice right! One needs to assess the impact of discreet re-balancing, transaction costs and volatility forecasting accuracy on the performance of trades. And that's when we start discussing delta - gamma hedging, daily re-balancing efficiency simulations, GARCH models...
Does not mean it's not possible to make money out of this strategy. Just means it takes a bit of reading and analysis to pick the right spots with the right tools.
On the reading part, thank god some smart dudes put some thought into it. So let me share the following links:
-> Michael Kamal and Emmanuel Derman on the risks associated to non-continuous hedging:
http://www.ederman.com/new/docs/risk-non_continuous_hedge.pdf
-> Riaz Ahmad and Paul Wilmott on volatility arbitrage and delta hedging:
http://www.math.ku.dk/~rolf/Wilmott_WhichFreeLunch.pdf
Hope you enjoy those!
Cheers,
Olivier
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